Second quarter results obscure widespread strength in earnings for most companies.

The recession that began in March 2001 has had a measurable adverse effect on bank credit quality, particularly among large commercial credits to corporate borrowers. This effect is evidenced by the $ 7.5 billion in loan charge-offs reported by the 25 largest banking companies (25 Largest) in the second quarter of 2002. However, the expectation of economic recovery this year raises the likelihood that bank credit quality will stabilize in future quarters and then begin to improve.

During the second quarter of 2002, a range of indicators pointed to at least a modest U.S. economic recovery. Housing starts remained robust while factory orders and payroll job growth resumed positive rates of growth. U.S. gross domestic product (GDP) increased at an annual rate of 1.1 percent in the second quarter, following a revised 5.0 percent rate of growth in the first quarter.1 Private-sector economists polled in July by the Blue ChipEconomic Indicators call for economic growth of 2.8 percent for 2002 as a whole. However, these expectations have been revised downward in recent months as certain indicators have pointed toward moderating growth. Most notably, the consumer confidence index fell in July to 97.1 from 106.3 in June and equity market indices fell broadly amid ongoing concerns about accounting and corporate governance issues.

Against this backdrop, net income for the largest 25 U.S. banking companies was a strong $14.7 billion. Factors supporting large-bank earnings included continued high net interest margins and higher loan volume, while loan loss provisions rose again in a climate of continued weak credit quality. The $14.7 billion in earnings for this group was one-third higher than a year ago, but 9.1 percent lower than reported in the first quarter of 2002. Return on assets was 1.25 percent, compared to 0.98 percent a year ago.

Driving the totals are the results of two companies, FleetBoston and Citigroup. When their results are excluded, combined net income for the remaining 23 companies was up by $407 million (3.8 percent). Of these 23 companies, 14 had net income increases during the quarter. During the first quarter, Citigroup booked a $1.3 billion gain on sale of stock by a subsidiary as nonrecurring revenue. This revenue accounts for all but approximately $200 million of the groups $1.5 billion second-quarter earnings reduction. From a year-to-year perspective (2nd quarter 2001 to 2nd quarter 2002), 20 of the 25 companies posted net income increases.

Return on assets ratio also bears closer scrutiny.

Return on assets (ROA) of the 25 Largest decreased by 14 basis points in the quarter to 1.25 percent. However, during the period 13 of the companies experienced ROA increases. A comparison of the ratios from the current period to those of the second quarter of 2001 reveals that 19 companies had improved ROAs, with nine having increases of more than 30 basis points. The 1.25 percent ROA for the quarter is well above the ratio levels achieved in the second half of 2001 (0.89 percent for the 3rd quarter and 0.96 percent for the 4th quarter).

A dozen companies increased Core ROA over the quarter, while two companies (FleetBoston and Mellon) suffered declines in this ratio in excess of 125 basis points. As a result, Core ROA declined for the 25 Largest to 1.29 percent from 1.34 percent in the previous quarter.

Net interest margins remain at high levels for the third consecutive quarter.

Despite a modest drop since year-end 2001, the groups net interest margin remained near its peak of 3.85 percent achieved in the final quarter last year. The groups net interest margin for the second quarter was a strong 3.78 percent, a drop of 5 basis points from the first quarter. Over the quarter, the margins in 11 of the companies increased, while they decreased in 11 others and stayed the same in the remaining 3 institutions. Despite the second-quarter drop in the net interest margin of the 25 Largest, it is still 42 basis points higher than it was at year-end 2000 (3.36 percent).

The current climate of low short-term interest rates and steep yield curves has been the key to net interest income growth and the maintenance of high margins. Another positive development for margins is that deposits, a relatively inexpensive source of funding, increased by 2 percent during the quarter.

The Board of Governors of the Federal Reserve, meeting in late June, left the benchmark overnight bank lending rate at 1.75 percent, a 40-year low. The discount rate also remained unchanged at 1.25 percent. Low interest rates stimulate loan demand and help asset quality by limiting borrowers' debt service burdens.

Loan volume rose at most companies.

On September 30, 2001, loans2 held by the 25 Largest totaled $2.375 trillion. Although loans have not reached that level since then, the $2.341 trillion figure represented an annualized 2.5 percent increase over the first quarter. Loan increases among the group were widespread, as all but eight companies showed positive growth in the quarter

Loan-loss reserves register modest growth; rise in nonperforming assets is concentrated in a few companies.

During the second quarter, nonperforming assets increased by 5.4 percent, while loan-loss reserves increased by only 0.8 percent. Growth in nonperforming assets (NPAs) has outpaced loan-loss reserve growth in eight of the last 10 quarters. During that time, the ratio of loan-loss reserves to NPAs dropped from 202 percent at the end of the 1st quarter of 2001 to its current 127 percent. A mitigating factor is that the loan-loss reserves to loans ratio remained at 2.1 percent, the same level it has been for the last three quarters.

Two companies (FleetBoston and Citigroup) accounted for $1.9 billion of the $2.0 billion aggregate increase in nonperforming assets during the quarter. The volume of NPAs fell in a majority (13) of the companies.

At the individual company level, the dynamic relationship between reserves and NPAs is noteworthy in three cases. In two companies (Citigroup and Wachovia), a rise in nonperforming assets was accompanied by a decrease in loan-loss reserves; in a third (Bank of New York) loan-loss reserves remained unchanged while NPAs rose.

Growth in charge-offs is not widespread.

An increase in charge-off volume typically occurs when the economy begins to rebound from a recession. Thus, the 9.1-percent increase in charge-offs in the second quarter of 2002 is not atypical. However, it should be noted that: (1) the majority of the $631 million increase reflects the results at FleetBoston, which reported a $593 million increase and (2) charge-offs were up by 50 percent or more in four other companies.

While the signs of economic recovery suggest that overall credit quality may improve in the near future, there remain several areas of concern in the near-term. These include: the record number of bankruptcy filings by publicly-traded companies in the recent past3; Brazil's currency problems; the potential for losses in portfolios of subprime loans; and the possibility of further surprises from accounting irregularities4.

Capital ratios remain high.

Total equity capital of the 25 Largest increased by $9.6 billion (2.6 percent) in the second quarter. The equity to assets ratio remained the same, at 7.94 percent, and the three regulatory capital ratios stayed at much the same levels they were in the previous quarter.

The Tier 1 leverage ratio, up by a basis point from the first quarter to 7.57 percent, set a new record for this publication. The other two regulatory capital measures, while down slightly from first quarter levels, also remained near their historic highs. The Tier 1 risk-based capital (RBC) ratio was down by 3 basis points to 8.74 percent. The Total RBC ratio dropped by 15 basis points -- to 12.34 percent -- from its record level in the first quarter of 2002.

On the individual institution level, most companies registered improvement in their capital ratios. There were 20 companies reporting early second quarter capital figures. Of these companies, only seven had second quarter decreases in the Tier 1 leverage and Tier 1 RBC ratios and eight had declines in the Total RBC ratio. Six (Bank of America, Bank of New York, BB&T, Comerica, Fifth Third and Mellon) of these companies had declines in all 3 ratios.

The increase in equity capital, coupled with the 9.1 percent drop in net income led to a 195 basis point fall (to 15.70 percent) in the groups return on equity from the first quarter.

Market capitalization drops along with market indices.

During a period of financial market turbulence, the composite price per share of the 25 Largest fell by 4.7 percent in the second quarter. Twelve of the 25 companies suffered price declines. Of the dozen decliners, six had price decreases of 10 percent or more. Without these six companies, the average price per share for the group would have risen by 1.5 percent.

The overall stock price decrease led to a decline of 8.2 percent in the groups market capitalization over the quarter. Market capitalization decreased at 13 of the companies and six of these suffered declines of 10 percent or more. Without these six companies, the groups capitalization would have declined only 0.2 percent.

The 8.2-percent decrease in market capitalization at the 25 Largest paralleled drop-offs in other market indices in the second quarter. Over the same period, the Dow Jones Industrial Average was down by 11.2 percent, the S&P 500 decreased 13.7 percent and the SNL Securities Index of publicly traded banking companies was down by 5.9 percent.

Earnings-per-share figures for eight of the 25 companies exceeded Wall Streets consensus expectations (by a combined 20 cents); six fell short (by a combined $1.31, $1.09 of which was accounted for by FleetBoston) and 11 came in as expected.

Merger activity picks up during the second quarter.

Three notable whole-bank mergers involving the 25 Largest were announced during the quarter. Each of these transactions had targeted asset values that exceeded the combined amount of the two announcements made last quarter.

The largest announced deal, by far, involves Citigroups May announcement of the purchase of Golden State Bancorp, Inc. for $5.8 billion in stock and cash. Golden State, headquartered in California, is currently the third largest thrift holding company in the U.S. Citigroup stated that it hopes to use Golden States extensive branch network to market its array of insurance and investment products in California.

Two other significant transactions were announced during the second quarter. In May, BB& T Corporation announced that it was acquiring Regional Financial Corporation and First South Bank for $275 million. Regional Financial is based in Florida and First South is a mid-sized thrift institution in Tallahassee, Florida. In late July, Fifth Third Bancorp announced that it was acquiring Franklin Financial Corporation and Franklin National Bank for $219 million. Franklin Financial is based in a suburb of Nashville, Tennessee.

FOOTNOTES

* This document is based on publicly available information provided by the companies it covers. It is intended for informational purposes only. It does not represent official policy or supervisory guidance from the FDIC.

The FDIC has assembled information from public data releases compiled by SNL DataSource for the 25 largest banking companies, as of August 4, to obtain an early look at the performance of these firms. Highlights are summarized in the narrative below. In addition, attached tables contain financial data and a merger chronology for each of the 25 Largest. Summary indicators for the group are presented on page 12.

This report only includes organizations primarily involved in commercial banking for which timely information is available. The bank subsidiaries of these 25 companies hold approximately 61 percent of the commercial banking industry's total assets. Excluded from this report are: foreign owned companies, some diversified financial service companies, thrift companies that concentrate on mortgage lending and nonbank financial services companies. Further details are presented on page 11.

1 Gilpin, Kenneth N. "Economic Growth Slowed Sharply in the 2nd Quarter." The New York Times. July 31, 2002.

2 Loans include loans held for investment and loans held for sale, net of unearned income.

3 There were a total of 176 filings in 2000, which was a record until surpassed by 257 in 2001. Of the latter, 33 percent involved companies related to the energy sector (including Enron) and 14 percent involved telecom companies (excluding WorldCom). Up until WorldCom's filing on July 21, 2002, five of the 15 largest bankruptcies in history came in 2001. WorldCom's bankruptcy is the largest in history.

4 Blackwell, Rob. "FDIC: Subprime, Business Loans at Risk. American Banker. June 19, 2002. It is presently thought that the WorldCom bankruptcy filing will not be that harmful to future earnings of the 25 Largest, primarily due to the worldwide syndication of its $2.65 billion unsecured loan. Of that amount, U.S. banks have roughly one-third on their books, with most (if not all) of this portion affecting the 25 Largest.